Goldman’s Options Error Shows Peril Persists After Knight

The Goldman Sachs & Co. logo is displayed at the company's booth on the floor of the New York Stock Exchange (NYSE) in New York. Photographer: Scott Eells/Bloomberg

Aug. 21 (Bloomberg) -- For all the efforts to shore up
electronic markets in the aftermath of one of America’s biggest
trading catastrophes, yesterday’s options malfunction by Goldman
Sachs Group Inc. shows the dangers haven’t gone away.

A programming error caused the firm to send unintentional
stock options orders in the first minutes of trading, pushing
prices on dozens of contracts to a dollar each, according to a
person briefed on the matter yesterday and data compiled by
Bloomberg. Any losses for Goldman Sachs, the fifth-largest U.S.
bank by assets, won’t be known until exchanges determine which
contracts should be canceled, said the person, who requested
anonymity because the information is private.

Investors who fret about the increasing dominance of
electronic exchanges say the error at Goldman Sachs, which
generated about half its revenue from trading last quarter,
shows that worse breakdowns are inevitable. A year ago, Knight
Capital Group Inc. was pushed to the brink of bankruptcy by a
trading breakdown, and Chinese regulators are investigating
broker Everbright Securities Co. after $3.8 billion of incorrect
buy orders sent the Shanghai Composite Index up about 6 percent
in two minutes last week.

“It can happen to anybody, no firm is immune,” Matt
McCormick, who helps oversee $9.6 billion as a money manager at
Cincinnati-based Bahl & Gaynor Inc., said in a phone interview.
“Because it’s Goldman Sachs, the error could be pretty large.”

Sorting Trades

Exchanges were working to sort out the trades and any loss
“would not be material to the financial condition of the
firm,” according to an e-mail from David Wells, a spokesman for
New York-based Goldman Sachs. The company’s shares slipped 1.5
percent to $157.11 today.

An internal system that Goldman Sachs uses to help prepare
to meet market demand for equity options inadvertently produced
orders with inaccurate price limits and sent them to exchanges
yesterday, according to the person familiar with the situation.
Some of the transactions have already been voided, data compiled
by Bloomberg show.

Error trades took place in the session’s first 13 minutes
for tickers beginning with the letters I, J and K and most of
the transactions may be canceled, according to a statement dated
yesterday from NYSE Euronext’s U.S. options business. NYSE and
Nasdaq OMX Group Inc. said today that they have completed the
trade reviews, according to e-mailed statements from the
exchanges.

“As is our practice, we have been monitoring developments
and talking with the exchanges and other market participants as
appropriate,” Securities and Exchange Commission spokesman John
Nester said in an e-mail.

Of the 500 biggest options trades in the first 15 minutes
markets were open yesterday, 405 of them were for tickers
starting with H through L and priced at $1, according to data
compiled by Trade Alert LLC and Bloomberg. Almost 130 of those
were in 1,000-contract lots.

Busting Trades

“To bust a trade in equities it’s relatively
straightforward, to bust a trade in options it would take more
time,” Howard Tai, a Kansas City, Missouri-based analyst with
Aite Group LLC, said in an interview. “You need to look at each
one of the factors and then run through a sanity check, and say,
‘Beyond the cash equity price at the time it happened, how did
everything else affect it?’”

Investors in China were whipsawed by a computer malfunction
last week. State-controlled brokerage Everbright reported a
trading loss of 194 million yuan ($32 million) and apologized to
investors after errors in order-execution systems on Aug. 16
sparked the biggest intraday swing in China’s benchmark index
since 2009. The incident touched off a 53 percent surge in
volume in the Shanghai Composite Index, which jumped from a loss
of as much as 1 percent to a gain of 5.6 percent in two minutes.

Everbright’s stock plunged by the 10 percent daily limit
yesterday after the China Securities Regulatory Commission
banned the brokerage from proprietary trading for three months
and started investigating what it described as the first
incident of its kind in China. The company said today that it
suspended its head of proprietary trading.

Goldman, Knight

At Knight, computers spewed orders onto exchanges on Aug.
1, 2012, that created a more than $450 million loss for the
brokerage. The mishap forced the company to near-insolvency
before it was acquired by Getco LLC and spurred calls to examine
whether increasing automation is damaging markets.

Knight had a $1 billion market value on July 31, 2012, the
day before the trading error, according to data compiled by
Bloomberg. Its stock fell 33 percent the next day. Goldman
Sachs, which saw its stock rise 0.6 percent yesterday, has a
market capitalization of $75 billion.

Goldman Sachs reported net income of $1.93 billion in the
second quarter on a surge in underwriting revenue and gains from
the firm’s own investments. In the quarter before its trading
mishap, Knight posted net income of $3.3 million.

Written Policies

The SEC proposed rules in March requiring U.S. exchanges
and some brokers to conduct coordinated trading tests to show
they can recover from disruptions. The mandate, called
Regulation Systems Compliance and Integrity, directs exchanges
to strengthen their technology and instruct member firms to
participate in tests to show they can sustain operations after
interruptions.

The proposed rule requires firms to have written policies
and procedures to ensure that systems supporting trading,
clearing, order-routing and surveillance have sufficient
capacity and remain available to their users. The technology
must operate as intended, be secure from threats and promote
fair and orderly markets. A review must be done at least once a
year by objective personnel, the SEC said.

The changes by trading firms, exchanges and regulators are
making the industry better at navigating technology mishaps and
human errors, said Ben Schwartz of Lightspeed Financial Inc.

The securities industry has “learned from the mistakes
we’ve made in the past and tried to grow a technology to
simplify a process and grow more consistent,” Schwartz, the
Chicago-based chief market strategist at broker Lightspeed
Financial, said in a phone interview yesterday. “It’s a
positive thing that they react immediately in a timely manner.”

Canceled Trades

Among yesterday’s canceled trades, 241 September $103 puts
on the iShares Russell 2000 Exchange-Traded Fund traded at $1 at
9:32 a.m. New York time, according to data compiled by
Bloomberg. That price was down from $3.32 two minutes earlier.
At the same time, 1,000 October $90 calls on Johnson & Johnson
traded at $1, followed less than 11 minutes later by two
contracts at $2.10.

“We’re all working too fast, too thin and we’ve got
systems that do things for you,” said Tim Hartzell, who helps
manage about $425 million as chief investment officer at Sequent
Asset Management in Houston. “You can make so many little
errors.”